In a detailed analysis, ING suggests that the European Central Bank (ECB) is likely to keep its interest rates steady during its July meeting. However, this stability is expected to be accompanied by a hawkish tone, setting the precedent for a probable rate increase in September. The financial markets have already largely factored in a September hike, underscoring the significant influence of geopolitical events, particularly the Iran conflict and its subsequent effect on global oil prices. These external factors are crucial in shaping both the future trajectory of interest rates and the exchange rate dynamics of the EUR/USD currency pair.
ING's scenario modeling outlines a "hawkish-leaning hold" as the most probable outcome for the upcoming ECB meeting. Under this scenario, the EUR/USD is projected to hover around the 1.140 mark, with 10-year German Bund yields stabilizing near 3.15%. A less aggressive stance from the ECB could see the EUR/USD retracting towards 1.130 and Bund yields falling to approximately 3.05%. Conversely, an unexpected 25 basis point rate increase would likely propel the EUR/USD to 1.150 and push Bund yields up to 3.20%. ING emphasizes that interest rates remain highly sensitive to oil price fluctuations, with a September rate hike almost fully discounted by the market unless a significant de-escalation in crude prices occurs. Regarding currency markets, ING believes that while a hawkish ECB is necessary to sustain EUR/USD above 1.140, it may not be sufficient, indicating a potential retest of the June low near 1.133 as a short-term risk.
The current market expectations reflect a consensus among analysts for the ECB to maintain its rates on July 23, with less than a 5% probability of an immediate hike. This stance follows June's rate adjustment, which was largely seen as a precautionary measure against rising energy costs rather than the beginning of a sustained tightening cycle. Nevertheless, the continuous stream of geopolitical and energy-related news since June suggests that a surprise rate increase should not be entirely discounted. Given the absence of updated economic forecasts at this particular meeting, the communication's tone will be critical. ING anticipates that the more assertive members of the governing council will continue to hold sway, thereby keeping market pricing aligned with the expectation of one or two further rate hikes before the year's end. This strategy aims to prevent inflation expectations from becoming unanchored. ING speculates that any confirmation of a September hike might emerge through informal media leaks post-meeting, a communication pattern that has become increasingly common.
On the bond market, ING observes that investor behavior mirrors reactions seen during previous phases of the Iran conflict, where oil price movements rapidly translate into altered monetary policy expectations. The market has nearly fully priced in a September hike, a sentiment that is unlikely to shift unless there is a substantial decline in oil prices. Even if the ECB were to implement an unexpected hike this week, ING interprets such a move as merely bringing forward the anticipated September increase, rather than signaling a more aggressive or prolonged tightening cycle. This interpretation stems from the understanding that an unanticipated hawkish move would likely suppress longer-term inflation expectations. Real interest rates are notably higher compared to several months ago, explaining why two-year euro swap rates have reached new peaks, even with Brent crude trading below $100 per barrel. This trend points to a stronger economic outlook and a more stringent interpretation of central bank policies, influenced in part by the less dovish-than-expected stance of Federal Reserve Chair Kevin Warsh.
In the foreign exchange market, ING notes that the two-year swap rate differential between the euro and the dollar has narrowed by approximately 25 basis points since the early July escalation in the Gulf region. This pattern is consistent with trends observed in March, suggesting that investors perceive greater flexibility for the ECB to adopt a hawkish stance compared to the Federal Reserve, given the eurozone's lower initial interest rate levels. Despite this, ING points out that market participants were reluctant to price the ECB's deposit rate above 2.75% by year-end, even during the spring oil rally, with current pricing closer to 2.65%. This implies that further increases in oil prices might provide diminishing support for EUR/USD through interest rate channels, potentially exerting more pressure through broader risk sentiment. ING concludes that while a hawkish ECB is a prerequisite for EUR/USD to maintain its position above 1.140, it alone may not be sufficient, leaving the possibility of the currency retesting June's low near 1.133 as a significant short-term risk.